Research

A theory of money needs a proper place for financial intermediaries. Intermediaries create money by taking deposits from savers and investing them in productive projects. The money multiplier depends on the size of intermediary balance sheets, and their ability to take risks. In downturns, as lending contracts and the money multiplier shrinks, the value of money rises. This leads to a Fisher deflation that hurts borrowers and amplifies shocks. An accommodative monetary policy in downturns, focused on the assets held by constrained agents, can mitigate these destabilizing adverse feedback effects. We devote particular attention to interest rate cuts, and study the potential for such policies to create moral hazard.

In a world with self-generated, endogenous risk and time-varying risk premia, price stability and financial stability are inseparable. A monetary analysis based on the distribution of liquidity mismatch across sectors provides valuable information about the build-up of vulnerabilities in tranquil times and helps to identify balance sheet impaired sectors in volatile times. When the monetary transmission mechanism becomes “sectorially impaired”, monetary policy action dis-proportionally favors issuers of government and large corporation debt over small and median enterprises (SMEs). Reviving a prudently designed asset backed securitization market for SME and consumer loans would alleviate this discrepancy and establish a pan European intermediation market.

This paper proposes a welfare criterion for economies in which agents have heterogeneously distorted beliefs. Instead of taking a stand on whose belief is correct, our criterion asserts an allocation to be belief-neutral inefficient if it is inefficient under any convex combination of agents' beliefs. While this criterion gives an incomplete ranking of social allocations, it can identify negative-sum speculation in a broad range of prominent models with distorted beliefs.

This paper reviews some of the most prominent asset price bubbles from the past 400 years and documents how central banks (or other institutions) reacted to those bubbles. The historical evidence suggests that the emergence of bubbles is often preceded or accompanied by an expansionary monetary policy, lending booms, capital inflows, and financial innovation or deregulation. We find that the severity of the economic crisis following the bursting of a bubble is less linked to the type of asset than to the financing of the bubble – crises are most severe when they are accompanied by a lending boom, high leverage of market players, and when financial institutions themselves are participating in the buying frenzy. Past experience also suggests that a purely passive “cleaning up the mess” stance towards inflating bubbles in many cases is costly. At the same time, while interest-rate leaning policies and macroprudential tools can and sometimes have helped to deflate bubbles and mitigate the associated economic crises, the correct implementation of such proactive policy approaches remains fraught with difficulties.

This paper provides a template for teaching the Euro crisis. It starts by stressing the importance of international capital flows that primarily fueled sectors with low productivity in the periphery. A key element of the crisis is that international capital flows were intermediated by banks and that most European banks rely heavily on less stable short-term wholesale funding. A sudden stop of this funding flows leads to fire-sales and a credit crunch. This is worsened by the ''diabolic loop'' between sovereign and banking risk. The paper addresses various liquidity policy measures and argues that insolvency issues are not addressed since fiscal authorities and monetary authority play a game of chicken about who should absorb the losses.

This paper documents that banks with higher non-interest income (noncore activities like investment banking, venture capital and trading activities) have a higher contribution to systemic risk than traditional banking (deposit taking and lending). After decomposing total non-interest income into two components, trading income and investment banking and venture capital income, we find that both components are roughly equally related to systemic risk. These results are robust to endogeneity concerns when we use a difference-in-difference approach with the Lehman bankruptcy proxying for an exogenous shock. We also find that banks with higher trading income one-year prior to the recession earned lower returns during the recession period. No such significant effect was found for investment banking and venture capital income.

This paper develops a framework for measuring, allocating and managing systemic risk. SystRisk, our measure of total systemic risk captures the a priori cost to society for providing tail-risk insurance to the financial system. Our allocation principle distributes the total systemic risk among individual institutions according to their size-shifted marginal contributions. To describe economic shocks and systemic feedback effects we propose a reduced form stochastic model that can be calibrated to historical data. We also discuss systemic risk limits, systemic risk charges and a cap and trade system for systemic risk.

We propose a measure for systemic risk, \Delta-CoVaR, defined as the conditional value at risk CoVaR of the financial system conditional on institutions being under distress in excess of the CoVaR of the system conditional on the median state of the institution. From our estimates of \Delta-CoVaR for the universe of publicly traded financial institutions, we quantify the extent to which characteristics such as leverage, size, maturity mismatch, and asset price booms predict systemic risk contribution. We also provide out-of-sample forecasts of a countercyclical, forward-looking measure of systemic risk and show that the 2006Q4 value of this measure would have predicted more than one third of realized \Delta-CoVaR during the financial crisis.

Traditional economics argues that financial derivatives, like CDOs and CDSs, ameliorate the negative costs imposed by asymmetric information. This is because securitization via derivatives allows the informed party to find buyers for less information-sensitive part of the cash flow stream of an asset (e.g., a mortgage) and retain the remainder. In this paper we show that this viewpoint may need to be revised once computational complexity is brought into the picture. Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Note that computational complexity is only a small departure from full rationality since even highly sophisticated investors are boundedly rational due to a lack of requisite computational resources.

This paper develops a dynamic two-country neoclassical stochastic growth model with incomplete markets. Short-term credit flows can be excessive and reverse suddenly. The equilibrium outcome is constrained inefficient. First, an undercapitalized country borrows too much since each individual firm does not internalize that an increase in production capacity undermines their output price and thereby worsens their terms of trade. From an ex-ante perspective each firm undermines the natural \lq\lq{}terms of trade hedge.\rq\rq{} Second, sudden stops and fire sales lead to sharp price drops of illiquid physical capital, another pecuniary externality. The analysis also provides a full characterization of the endogenous volatility dynamics and welfare. Imposing capital controls or other domestic macro-prudential policy measures that limit short-term borrowing can improve welfare.

This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly nonlinear amplification effects, the economy is prone to instability and occasionally enters volatile crisis episodes. Endogenous risk, driven by asset illiquidity, persists in crisis even for very low levels of exogenous risk. This phenomenon, which we call the volatility paradox, resolves the Kocherlakota (2000) critique. Endogenous leverage determines the distance to crisis. Securitization and derivatives contracts that improve risk sharing may lead to higher leverage and more frequent crises.

Liquidity and deflationary spirals self-generate endogenous risk and redistribute wealth. Monetary policy can mitigate these effects and help rebalance wealth after an adverse shock, thereby reducing endogenous risk, stabilizing the economy, and stimulating growth. The redistributive channel differs from the classic Keynesian interest rate channel in models with price stickiness. Central banks assume and redistribute tail risk when purchasing assets or relaxing their collateral requirements. Monetary policy (rules) can be seen as a social insurance scheme for an economy beset by financial frictions. As with any insurance, it carries the cost of moral hazard. Redistributive monetary policy should be strictly limited to undoing the redistribution caused by the amplification effects and by moral hazard considerations.

This chapter surveys the literature on bubbles, financial crises, and systemic risk. The first part of the chapter provides a brief historical account of bubbles and financial crisis. The second part of the chapter gives a structured overview of the literature on financial bubbles. The third part of the chapter discusses the literatures on financial crises and systemic risk, with particular emphasis on amplification and propagation mechanisms during financial crises, and the measurement of systemic risk. Finally, we point toward some questions for future research.

”. Advances In Economics And Econometrics, Tenth World Congress Of The Econometric Society. New York: Cambridge University Press, 2013. Print.Abstract

This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to non-linear amplification eects. Risk is endogenous and liquidity spirals cause financial instability. Increasing margins further restrict leverage and exacerbate the downturn. A demand for liquid assets and a role for money emerges. The market outcome is generically not even constrained ecient and the issuance of government debt can lead to a Pareto improvement. While financial institutions can mitigate frictions, they introduce additional fragility and through their erratic money creation harm price stability.

What makes a good leader? A good leader is able to coordinate his followers around a credible mission statement, which communicates the future course of action of the organization. In practice, leaders learn about the best course of action for the organization over time. While learning helps improve the organization's goals it also creates a time-consistency problem. Leader resoluteness is a valuable attribute in such a setting, since it slows down the leader's learning and thus improves the credibility of the mission statement. But resolute leaders also inhibit communication with followers and leader resoluteness is costly when followers have sufficiently valuable signals.

We develop a model of endogenous maturity structure for financial institutions that borrow from multiple creditors. We show that a maturity rat race can occur: an individual creditor can have an incentive to shorten the maturity of his own loan to the institution, allowing him to adjust his financing terms or pull out before other creditors can. This, in turn, causes all other lenders to shorten their maturity as well, leading to excessively short-term financing. This rat race occurs when interim information is mostly about the probability of default rather than the recovery in default, and is most pronounced during volatile periods and crises. Overall, firms are exposed to unnecessary rollover risk.

The aim of this paper is to conceptualize and design a risk topography that outlines a data acquisition and dissemination process that informs policymakers, researchers and market participants about systemic risk. Our approach emphasizes that systemic risk (i) cannot be detected based on measuring cash instruments, e.g., balance sheet items or ratios such as leverage and income statement items; (ii) typically builds up in the background before materializing in a crisis; and (iii), is determined by market participants’ endogenous response to various shocks. Our measurement system asks that regulators elicit from market participants their (partial equilibrium) risk as well as liquidity sensitivities (our response indicator) with respect to major risk factors and liquidity scenarios. General equilibrium responses and economy-wide system effects can be calibrated using this panel data set.

In many situations, timing is crucial—individuals face a trade-off between gains from waiting versus the risk of being preempted. To examine this, we offer a model of clock games, which we then test experimentally. Each player's clock starts upon receiving a signal about a payoff-relevant state variable. Since the timing of the signals is random, clocks are de-synchronized. A player must decide how long, if at all, to delay his move after receiving the signal. We show that (i) delay decreases as clocks become more synchronized, and (ii) when moves are observable, players “herd” immediately after any player makes a move. Our experimental results are broadly consistent with these two key predictions of the theory.

Should we regulate complex securities, subject them to an FDA-style approval process, or limit who can invest in them? To answer these questions, one first needs to establish why complexity matters, and what defines a complex security. Complexity is an important concept in financial markets with boundedly rational agents, but that finding a workable definition of complexity is difficult. For example, while CDOs are viewed by most as highly complex, equity shares of financial institutions, whose payoff structures are even more complicated, are often seen as less complex. We point out three different ways in which boundedly rational investors can deal with complexity: (i) by dividing up difficult problems into smaller sub-problems or by using separation results, (ii) by using models – simplified pictures of reality, (iii) through standardization and commoditization of securities. Importantly, simply increasing the quantity of information disclosed to investors does not resolve complexity, since in the presence of bounded rationality it leads to information overload..